Question

3. The Ice Rider Manufacturing makes snowmobiles, some of which it sells to Japan for recreation in the wilderness of the northern islands. Ice Rider is expecting a payment of ¥9 million in six months.

a. Draw a timeline illustrating the underlying transaction.

b. Draw a payoff profile of the underlying transaction with dollars-per-yen on the axes.

c. Suppose Ice Rider takes out a forward contract to hedge this transaction. Describe this contract.

d. Describe the advantages/disadvantages to Ice Rider if Ice Rider takes out a futures contract instead of a forward contract.

Answer 1

Part (a)

Cash flow timeline:

At t = 0.5 years:

• Receipt of ¥9 million
• Convert ¥9 million into USD

Part (b)

If F is the USD per yen exchange rate then

Payoff profile of the underlying transaction = F x A = F x 9 million = USD 9F million

Hence, the profile will be:

Part (c)

The contract should a forward contract to sell ¥9 million in six months at a pre determined dollars-per-yen rate.

Part (d)

Advantages of future over forward:

• Future contracts are exchange traded while forward contracts are over the counter products.
• Since they are exchange traded, future contracts have lower counter-party risk than forward contracts.
• Generally cash settled; physical delivery not required

Disadvantages

• Future contracts are standard contracts. They can't be customized like forward contracts.